Monday, January 20, 2014

These days, my feelings about the US equity market are much like those of Jeff Gundlach and Jim Stack. All system lights are green. Valuations are elevated but not at bubble levels (see Gavyn Davies' How to detect a market bubble for a good discussion on this topic). While I believe that stock prices can make further highs in the next few months, I remain more cautious later in the year (see My plan for 2014).

In a recent interview, Gundlach displayed the same sense of unease that I feel - that conditions are too good to last and compared the current market to 1999:

What’s next for stocks now?
There is tremendous optimism and great belief in the equity markets. I think the stock market today is very similar to where the gold and silver markets were in March to May of 2011. They just kept going up. I remember going to meetings where people were like «Ah … I think we should buy gold and silver». At that time Silver was at about $42 and it went to $50 but then dropped to $20. That’s how I think of the market today.

What’s your advice for investors?
I’m not interested in buying equity markets now, particularly not the ones who have done the best like the US. I feel like putting new money to work in equities today is like buying silver at $42 in the spring of 2011. It may go higher. But just like silver at $42: You’re seeing a great amount of capitulation. It does feel like an echo of the late nineties in terms of market behavior. People are saying: «I can’t see any justification for the market not going higher, everything points to the market going higher». Well, I remember a similar mood in early 2000. At that time, an equity manager working for me said: «This is a stock market Nirvana. I have never seen better conditions for the stock market». So I said: «That probably means that things can’t get any better». It reminds me of a triple-A rated bond: There’s only one way for it to go: get downgraded.

Howard Gold at Marketwatch wrote about Jim Stack, who correctly called the 2007 top and the subsequent bottom, and characterized Stack as turning cautious on stocks, mostly because of the Presidential cycle:

Stack isn’t reducing his recommended stock exposure, but he is watching the economy and some technical indicators like the advance/decline line (which tracks changes in the number of stocks with price gains vs. the number with declining prices) and his own proprietary index of bellwether (market-leading) stocks.

Recently that indicator has put out some cautionary signs, too, by “moving sideways over the last six months while the market has been hitting new highs.”

“It’s not the kind of divergence we’ve seen in 2000 and 2007,” he told me, but it’s divergence nonetheless.

So, what does his gut tell him?

“My gut tells me we’re in the latter innings of this ball game,” he said in our interview. And he had a clear warning for investors who’ve been out of the market until now and are thinking of jumping into stocks again.

“Don’t increase your exposure or increase your risk at this point in the bull market,” he said. “The last thing you want to do is take a position that’s been mostly in cash and invest aggressively.”

What are the bearish triggers?
I've therefore been thinking, what are the bearish triggers? An ugly, claw your eyes out bear market where stock prices are down 30% or more is unlikely to occur without a recession - and there is no sign of that on the horizon. However, a slowdown or growth scare isn't out of the question. Such a scare could result in a stock market setback of 10-20% this year.

Let me first say that 20% downturns are part of equity investing and long-term equity investors should be prepared to stomach this kind of market action. If you can't stomach that kind of volatility, then you shouldn't be in the stock market.

What are the bearish triggers for a 10-20% correction? I present below three scenarios, starting from the most likely.

Housing weakness spooks the market?
The first and most likely scenario is a downturn in housing. Housing is very cyclically sensitive. Its plunge pushed the US into the Great Recession and its recovery took us out of recession. New Deal Democrat highlighted a paper by Edward Leamer. which was presented at Jackson Hole in 2007, showing the importance of housing to the economy [emphasis added]:

After residential investment as a contributor to prior weakness come consumer durables, consumer services, and then consumer nondurables. Those are all consumer spending items -- it's weakness in consumer spending that is a symptom of an oncoming recession.... The timing is: homes, durables, nondurables, and services. Housing is the biggest problem in the year before a recession... durables is the biggest problem during the recession [although consumer durables declined even more than housing before 2 of the 10 post World War II recessions]

That's why New Deal Democrat is worried about a slowdown in housing because of rising mortgage rates:

Two significant arguments contra my contention that housing demand will actually decrease at least for awhile YoY this year are that (1) there is a lot of pent-up demand, and (2) interest rates at 3% are still low so there shouldn't be that much of a reaction.

Fair points. But this isn't the first time that there has been pent-up demand for housing in an era of low interest rates. While the statistical series aren't identical, they clearly show that there was a huge housing bust during the Great Depression, that lasted through World War 2. Then all the GI's came home in 1945 and got busy making babies. Boom!

I won't go through all his charts, but he went on to show the inverse correlation between housing starts responded to long-term interest rates in the 1940's and 1950's, a period characterized by pent-up demand for housing.

Indeed, Bespoke has shown that homebuilder sentiment started to slip in January, though readings are not levels where investors are inclined to panic.

As well, Marketwatch pointed out that the latest earnings reports from the largest mortgage lenders show that mortgage origination is dropping.

I am carefully watching the relative performance of the homebuilding stocks to the market. As the chart below shows, this group is undergoing a period of relative consolidation after making an intermediate term relative top. However, there is an eerie mirror image similarity to the price action in 2012. Then, homebuilders consolidated sideways on a relative basis before continuing their relative uptrend. Will they consolidate sideways and continue their relative downtrend in 2014? Or will they recover?

Inflation scare = Fed tightening
A second scenario that could derail the bulls' train is the perception of rising inflation, which could prompt the Fed to prematurely tighten monetary policy. While the Fed may not actually raise rates, even the threat of rising rates could throw the stock market into a tizzy (also see my recent post The risk of catastrophic success).

For now, core PCE, which is the Fed's favorite measure of inflation, remains tame:

However, the threat of asset inflation is starting to rise. This chart of the relative performance of Metal and Mining stocks to the market shows that this group rallied out of a long-term relative downtrend and appears to be undergoing a period of sideways consolidation. If the relative performance of these stocks tick up, then watch for Mr. Market to get nervous about rising inflation and Fed tightening.

As well, I am also watching the price of Sotheby's as a proxy for the price of hard assets like collectibles. Will it break out of the current trading range to the upside or the downside?

No discussion of asset inflationary pressures would be complete without highlighting Warren Buffett's recent high profile purchases into the asset inflation sensitive energy sector, namely Suncor, ExxonMobil and Philips 66. What does he know that the rest of us don't know?

For now, the threat of asset inflation remains tame. Nevertheless, I can imagine a scenario where the combination of a weakening housing sector and rising inflationary expectations/Fed tightening lead to fears of stagflation and substantial stock market losses.

Tail-risk from China
As well, there is the ever present risk of a financial implosion in China. I have written extensively about these risks and I won't repeat them here (for a summary see this).

Could China's financial system crack? The potential failure of a wealth management product marketed by a major Chinese bank could be a test case for both investor confidence and moral hazard, according to this Reuters report [emphasis added]:

Industrial and Commercial Bank of China, the world's largest bank by assets, said on Thursday that it has no plans to use its own money to repay investors in a troubled off-balance-sheet investment product that it helped to market.

ICBC’s shares have fallen this week amid speculation that the bank would be forced to help repay investors in a 3 billion yuan ($496.20 million) high-yield investment product issued by China Credit Trust Co Ltd but marketed through ICBC branches. The product is due to mature on Jan. 31…

“Regarding this unsubstantiated rumour, a situation completely does not exist in which ICBC will assume the main responsibility (for the trust product),” an ICBC spokesman told Reuters by phone on Tuesday.

Here are the gory details [emphasis added]:

The trust product, called "2010 China Credit / Credit Equals Gold #1 Collective Trust Product", used the funds it raised from wealthy investors in 2010 to make a loan to unlisted coal company Shanxi Zhenfu Energy Group Ltd.

But in May 2012, Zhenfu Energy's vice chairman, Wang Ping Yan, was arrested for accepting deposits without a banking licence.

Following an investigation, China Credit Trust told investors that Zhenfu Energy had taken out high-interest underground loans totaling 2.9 billion yuan, bringing its total liabilities to 5.9 billion yuan and threatening its ability to repay the trust loan.

China's coal industry has been battered by falling prices over the last year. Several other banks and trust companies are facing losses on loans to another coal company, Liansheng Resources Group.

Analysts have expressed increasing concern in recent years about Chinese banks' exposure to off-balance-sheet risks.

While trust products and other so-called wealth management products typically don't carry a formal guarantee from banks that help to create and sell them, bankers worry that investors widely perceive them as carrying an implicit guarantee from state-owned banks.

Business Insider reports that this problem is widespread. Not only has local government debt been rising, they have mainly been financed by the shadow banking system through the use of "wealth management products":

Rising local government debt has had many concerned about an impending financial crisis in China. The latest audit of Chinese government debt, showed that local government debt is up to 17.9 trillion renminbi (about $2.8 trillion).

And shadow banking, including the use of wealth management products (WMPs) — a pool of securities like trust products, bonds, stock funds that offer higher yields than bank deposits and are sold as low-risk investments — has been one of the main sources of credit for local governments.

We've seen WMPs rise 47.4% in Q3 2013, from a year ago. Trust products are up 60.3% in the same period and LGFV bonds are up 59.7% on the year.

In the past five weeks, we've seen sales and yields of WMPs spike. Eighty-three percent of WMPs sold in the last five weeks have seen an expected return of 5-8%, an all-time high, Cui points out.

The IMF chimed in and warned that China's finances are weaker than what the official data shows, because of local government debt:

The mainland's fiscal position is weaker than official data shows but not significant enough to cause alarm, the IMF said in a report released yesterday.

The International Monetary Fund also warned that the mainland was now "more vulnerable to a macroeconomic shock" because of its higher debt and bigger deficit.

It estimated that the mainland's augmented fiscal debt, which mainly refers to borrowing by local governments, rose to about 45 per cent of its 51.9 trillion yuan (HK$66.6 trillion) gross domestic product in 2012.

"The rise in augmented fiscal debt, however, is indicative of underlying challenges in local government finances," the report said.

What happens when some of these local government financed WMPs default and the (government-owned) bank that marketed them won't stand behind them? Could it shake the confidence of Chinese investors? If so, what are the possible global contagion effects given the size and role of the China in the world's economy?

Will the "2010 China Credit / Credit Equals Gold #1 Collective Trust Product" mark the beginning a Countrywide-like death spiral, which kicked off the Subprime Crisis and subsequent Lehman Crisis, or a Dubai default of 2009, which the market shrugged off?

For now, credit markets remain relaxed about any potential crisis in WMPs. The relative performance of Dim Sum bonds to US Treasuries remain in a relative uptrend, indicating no signs of stress in the system.

Needless to say, if the Chinese financial system were to implode and the contagion effects spread into the global financial system, the downside risk in US stock prices will not be limited to 20%.

Watching for bearish triggers
For now, all system lights are in the green for stock prices. I agree with BCA Research's assessment of US equities. The current cyclical upswing remains supportive of higher equity prices:

Our profit model is signaling continued positive growth ahead, consistent with persistent dividend hikes, and rising government tax receipts. Reduced fiscal drag and policy uncertainty in 2014 will remove a major barrier to business confidence, and thus investment.

However, you should watch out for the potholes:

[M]acro conditions will remain supportive of the overshoot in equity prices for a while longer, but only until Treasury yields become restrictive. In this environment, it makes sense to focus on profit performance rather than expectations for further valuation expansion. Deep cyclical sectors provide protection against rising bond yields and are well positioned to deliver better-than-anticipated profitability.

My inner investor is nervously staying long, but watching for the bearish tripwires to be triggered.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.” None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

No comments:

We've moved!

Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

DISCLAIMERThis is not investment advice! I know nothing about you, your risk preferences, your portfolio or your investment horizon. I have no idea whether any of my opinions expressed are suitable for you.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. I may hold or control long or short positions in the securities or instruments mentioned.